Game theory

Business leaders and, indeed, people in general, differ greatly in what they are able to accomplish with given amounts of resources. Consequently, small armies led by brilliant military strategists sometimes defeat large armies commanded by unimaginative generals. Skilled poker players may be consistent winners even if, on average, they are dealt poor cards, while mediocre play­ers usually walk away from a game as losers de­spite average or better cards. And one firm may fail miserably, while an apparently similar firm prospers. Luck is sometimes a decisive factor, but even more frequently, correctly forecasting the behavior of your friends or rivals and then developing an effective strategy is the key to suc­cess or failure.

Economists who consider strategic behav­ior⁴ stress that (a) a single firm's actions may af­fect industrial concentration, (b) dynamic decisions (decisions made over time) are invari­ably rational, and (c) differential information shapes firm behavior and market structure.

This first point leads to the idea that, either individually or jointly, firms often pursue strate­gies to bar entry into their industry; potential competition often determines incumbent firms' current pricing and output policies. For exam­ple, banks located close to each other may unite to oppose the chartering of a new bank, citing the low interest rates they charge, lack of need for another bank, their willingness and ability to accommodate all creditworthy applicants for loans, and their service to the community.

The second point is that firms, like all eco­nomic agents, make sequential rational deci­sions over time. What you will do in a particular situation depends on what you learned from ex­perience after making decisions in similar situ­ations. Firms consider the previous reactions of their rivals when planning a business strategy. Dynamic game theory models of rational deci­sions extend the boundaries of earlier theory.

The third point recognizes that bargaining parties may have different information about po­tential transactions that often affect incentives and decisions. For example, a firm's manager may know that a huge layoff is scheduled as soon as a contract is completed but may try to keep workers from looking for other jobs through false reassurances that the firm has a pending new con­tract to be fulfilled. This type of knowledge asym­metry is common. Traditional models that treat information as free and perfect, or that assume that all transactors share the same information base, typically yield different conclusions than models that recognize asymmetric information.

The 1994 Nobel Memorial Prize in Economics was awarded to John Nash, John Harsanyi and Reinhard Selten for their pio­neering work in game theory and strategic bar­gaining. 2359 digits

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